The unsurprising decision by the European Central Bank last Thursday to increase its main interest rate needs to be seen in context. Press comment has focussed almost entirely on the woes of mortgage borrowers.
he policy rate will now be 1.25 per cent and even with a sequence of further increases expected over the balance of the year the rate will still be low by historical standards in a year's time. While any increase is unwelcome for Ireland and the other recession-hit peripheral economies, it is less than a disaster for most mortgage borrowers. More than half are on tracker rates. Trackers dominated through the market frenzy of 2005 to 2007 but for the last two years the lucky borrowers have been paying at bargain retail rates of two per cent or a little higher. The deal was the ECB rate plus one per cent or so. Tracker rates have fallen sharply in line with the ECB rate since the loans were taken out. Some holders of trackers are doubtless in negative equity, but are paying far less than they bargained for and are not under the same cash-flow pressure as are less fortunate borrowers on variable rates, whose monthly payments have been rising. The banks are losing money on trackers and are unable to do anything about it. But they are free to make up these losses by upping their variable rates and have chosen to do so.
Luckiest of all are those who re-financed older mortgages into trackers during the credit bubble. Many of these folks should be in clear positive equity even with the decline in house prices and are enjoying rock-bottom interest costs as well. There have been silent winners as well as vocal casualties in the Irish mortgage lottery. The media, including the taxpayer-financed public service broadcaster, can always be relied upon to ensure a loud voice to the losers and a discreet silence for the winners.
The more important message from the ECB is that interest rate policy into the medium term is being set, inevitably, to suit macroeconomic circumstances in the Eurozone as a whole. Economic developments in Ireland are thoroughly out of sync with mainland Europe and it does not suit us to face rising interest rates and a strong euro. This is a mirror image of the unfortunate pattern a decade ago, when the euro went through a period of weakness, ECB interest rates were low, and the Irish economy was boosted at a time when no stimulus was appropriate. The boom got boomier, in Bertie Ahern's memorable rendition, and it now looks as if the bust is about to get bustier, and all courtesy of a common currency area Ireland chose to join for political rather than economic reasons. If Irish politicians had chosen not to abolish our own currency in 1999, we would now be able to address the macroeconomic crisis without reliance on a monetary policy designed by somebody else, to handle somebody else's problems. There is little sympathy from the euro's designers for countries which chose the strait-jacket of the common currency against their own best interests, and who proceeded, as the designers would see it, to ignore the implications.
There is some kind of generational factor determining attitudes to the prospects for success in persevering with current policy. Older people, who remember that Ireland got into a dreadful mess in the 1980s and escaped, seem to think that we can repeat the manoeuvre. While accepting that unilateral policy adventures are inadvisable and that the Looney Tunes people advocating nuclear options are enjoying the irresponsibility of opposition, I am not optimistic that a sole reliance on budgetary tightening will do the trick. People who argue that Ireland should just 'stick to the programme' and all will turn out well are relying, perhaps unconsciously, on the successful escape from the 1980s public finance crisis. Unfortunately the line that Ireland had a big national debt at that time and managed to handle it without default does not offer a template for the resolution of the current crisis. The exit debt-to-GNP ratio will be far bigger this time. The banks did not go bust in the 1980s, it was just the government. Ireland had its own currency and the well-timed devaluation of August 1986 made a big difference. Crucially, the sovereign debt markets were rather indulgent in the late 1980s and fiscal miscreants were tolerated. High rates of economic growth helped to repay the debts of the 1980s, but are more readily achieved off a low base. Ireland cannot catch up with European real income levels again, having already done so. Caution about medium-term growth prospects is consistent with the lessons of economic history.
It has been an enduring feature of Irish policy through this crisis to misread the sea-change in bond markets subsequent to the 2008 meltdown. Last week's modest recovery in Irish bond prices was greeted by commentators who should know better as some kind of deliverance. Policymakers need to be brutally clear that these are unforgiving bond markets which will take a decade to recover from the nervous breakdown of 2008. It will be very difficult for Ireland, Greece and Portugal to re-enter the markets on reasonable terms for many years to come. The presumption that this will be easy is the least credible component of Ireland's deal with the IMF/EU of November last.
But none of this means that the Government can decline to 'stick to the programme'. Indeed, the programme for budgetary correction needs to be accelerated. A sustainable economic recovery needs an early restoration of confidence above all. There has been a devastating destruction of confidence in Ireland's capacity to meet its financial obligations on the part, not just of foreign financiers of both Government and banks, but also on the part of business investors and the general public. The collapse in private investment will not be reversed without a restoration of confidence, which requires measures under three headings.
The immediate priority is the restoration of credibility to the banking sector, and the latest estimates of loan losses are more credible than those which went before. Re-capitalising the banks with more borrowed money however places further pressure on the budget, at the expense of the second priority, the restoration of stability to the public finances. A programme to restore belief in recovery must also include specific measures to reduce business costs without worsening the budget. There is no evidence of any urgency whatsoever on this critical agenda item.
Our European 'partners' have, it would appear, vetoed the sharing of losses with those holding bonds issued by Irish banks now officially insolvent, in several cases many times over. The 'transfer union' so feared by the German populist media has already been made flesh through the imposition of liability for loan losses by publicly-owned German banks on Irish and other periphery taxpayers. The perception, entirely accurate, that this is unfair as well as unwise, will do great damage to the European project. One consequence is that the Irish Government's finances are over-stretched to the point where the markets expect default.
There is one, and only one, policy instrument available to Government which will improve confidence quickly and that is the pace of deficit reduction. Rather than accelerate the plans in the agreement with the IMF/EU, the new Government has already chosen to relax them. The forthcoming 'jobs budget' will apparently contain tax-reducing and expenditure-increasing measures which will have to be offset if even the new relaxed deficit target is to be met. This will be regretted sooner rather than later.
No longer able to cut our exchange rate and exiled from the markets, the one policy instrument entirely in the Government's hands is the timetable for deficit reduction. The palpable lack of urgency about getting the borrowing under control owes much to an inaccurate and lazy recollection of the 1980s, when a sluggish approach was permitted by the markets and did not end in a loss of sovereignty. But we are already reliant on official lenders, shut out from the markets. Having abolished the Irish currency to join the euro there is no devaluation option. The banks are officially insolvent. None of these things was true in the 1980s, when the budget correction was far too slow and yielded a wasted decade of emigration, business failure and stagnant incomes. Any plan to speed up the restoration of budget balance will have a short-term deflationary impact and it would be dishonest to pretend otherwise. But what other course of action is available which promises an early exit from reliance on unsympathetic European lenders and a restoration of confidence?
This time it's different.
Colm McCarthy lectures in economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua
